ECB tightens noose on Southern Europe

The European Central Bank has raised interest rates a quarter point to 1.5pc
to curb inflation and signalled more to come, despite faltering growth in
southern Europe and acute stress in peripheral bond markets.

Interest rates were raised to 1.5pc by the European Central BankPhoto: Bloomberg News

Jean-Claude Trichet, the ECB's president, brushed aside warnings that tightening at this delicate juncture might push Spain and Italy into the danger zone, insisting that every eurozone country stands to lose if the ECB fails to anchor price stability. Inflation risks "remain on the upside", he said, using coded language that opens the door to further rate rises over the Autumn.

As expected, the ECB waived its collateral requirements on Portuguese bonds, clearing the way for the country's banks to continue tapping the ECB's liquidity window following Moody's downgrade of Portugal's debt to junk. The ECB has already waved the rules for Greece.

Unlike Anglo-Saxon peers, the ECB is unwilling to gamble that inflation will fall back after spiking to 2.7pc in June on fuel and food pressures. But the hardline policy contains its own risks.

Yields on Italian 10-year bonds rose to a post-EMU high of 5.21pc yesterday. Spanish yields reached 5.71pc before settling down slightly. The bond jitters follow a slew of grim data pointing to an economic relapse in both countries.

"The debt problems are contained in Spain and Italy for now but the eurozone is dealing with finer and finer margins," said Simon Derrick, currency chief at the BNY Mellon.

"The situation is magnitudes worse than where we were a few months ago and the global outlook is following the pattern of mid-2008 before the Lehman crisis, so people are getting nervous," he said.

Italy's finance minister, Giulio Tremonti, unveiled a draconian plan yesterday to balance the budget by 2014 and stay a step ahead of the bond vigilantes, warning of "disaster" unless €48bn of cuts were passed. "What is at stake is the survival of civil society in this country," he said.

With low private debt, Italy has managed to stay out of the maelstrom so far. However, its public debt is the world's largest after the US and Japan at €1.84 trillion. The upward creep in yields has begun to attract unwelcome attention, notably among Asian investors.

Hans Redeker, currency chief at Morgan Stanley, said the danger for the eurozone is that long-term investment inflows have dried up. They have been replaced by a growing reliance on hot money funds, attracted by Europe's higher rates.

"This money is fickle. It will move out on the slightest sign of trouble. Europe's capital flows are sounding alarms," he said. By raising rates, the ECB may have made matters worse.

Mr Trichet emphatically opposed any form of selective default on Greek debt, fearing that it could scare away investors and set off fresh contagion in the eurozone. "We say, no, full stop," he said.

Europe's political leaders have the ultimate say however and they are hardening their stance on private sector "burden sharing". The Dutch finance minister, Jan Kees de Jager, told The Daily Telegraph that it would be "very difficult" to secure voluntary participation from the banks so other methods will be needed.

"We are exploring several possibilities. If we continue down the current road, all private debt in Greece will be converted into sovereign debt and we will have bailed out the banks," he said.

The ECB has the unenviable task of trying to bridge the North-South gap with a single interest policy. Germany's industrial machine is powering ahead on exports to China, Russia, and the Mid-East; while Spain seems trapped in near-depression, with unemployment at 21pc.

The ECB's monetary tightening has asymmetric effects, with greater impact on heavily-indebted and rate-sensitive economies in Spain and Ireland than on core Europe.

Over 90pc of Spanish mortgages are priced off the floating 1-year Euribor rate, which has risen 66 basis points to 2.19pc this year. Only 20pc of German loans are on floating rates.

Rate rises are ratcheting up the pressure as each month a fresh cohort of Spanish households sees a sharp upward adjustment in their mortgage payments. There is a hangover of 680,000 unsold properties on the market, according to government figures.

"There is no sign of recovery," said Raj Badiani from IHS Global Insight. "House sales are falling again at double-digit rates and if this spills over into 2012, the pressure on the Spanish banking system could become unbearable," he said.